Preventing Fraud in Troubled Companies

In an economic downturn, many companies begin to encounter issues with their primary lenders as a result of financial losses and diminishing liquidity.

Having worked as a CPA/Controller at many companies in different industries, and having been audited multiple times, I have always had a finger in the controls side of organizations. As I began a project recently little did I know that what was envisioned to be typical accounting work would turn into a fraud engagement.

I started some financial statement work at “Company B” and a related entity, “Company C”. Both had the same 2 owners, and shared 3 offices and were both $2.5 million, profitable companies. I met with a colleague and noted various points about looking at accruals, intercompany transaction, loans, cutoffs, deferred revenue etc. When we talked about fixed assets, he pointed out that a payment of $3000 to the company’s bookkeeper, “Dee” should be capitalized as the Quickbooks description was for office improvements.

I verified some tax/year-end entries that hadn’t been made into the accounting system yet. I was switching back and forth in the online system between Company B and Company C. I would note similarities, differences, and my curiosity kicked in and prompted me to pick up on something. I was trying to understand the business, look for exceptions in accounting and determine what steps might need to be done.

I was thinking about the $3000 transaction in Company B and for some reason looked up entries to Dee in Company C. I noticed multiple transactions in 2008 of several thousand dollars each, and made a note of it on my list of items to follow up on. I thought this situation was different than companies I had dealt with in the past to have an employee reimbursed so often for expenses that could have been paid directly to vendors. But then I thought maybe this was a “progressive” way of accounting, and there was a lot of trust in Dee and maybe she was in a position of paying for many company expenses and being reimbursed. As I found, many employees were given company credit cards; the difference was she had statements mailed to her house.

I returned to my office Monday and was mentioning the Dee’s check to a colleague and he thought this was unusual so we arranged a meeting at the client’s 3rd office, which had no employees currently, but which housed many accounting files. So far Dee had not provided much support for items we asked about. There were cancelled checks, invoices and other items which we reviewed for irregularities. To me it seemed some signatures on checks to her were different from signatures on other checks, but mainly we documented what files existed and copied certain items of significance. Our next in a series of discoveries firmed up our suspicions that something was awry. The “N” files (Dee’s last name) were missing.

A few days later we returned to the main client office and confronted her about the transactions and missing backup. Apparently she had been undergoing tremendous stress recently and had even been hospitalized. Perhaps I didn’t spell it out to others but I sensed something unusual about her. I didn’t know how much her clothes cost or her lifestyle habits but there was something too sophisticated about her for someone making $50,000 and booking invoices all day. The tact Dee took every time a question was asked of her was to refer us back to the accounting software. Source documents were not provided. Even when it seemed easy to obtain AMEX statements online there was obfuscation. Within days she was terminated and accused of embezzlement.

I put a spreadsheet together documenting all items in question, and after accounting for questionable AMEX and Visa charges, it totaled nearly $300,000. There were 2 mechanisms for taking company funds. The first scheme was to book credit card expenses of a particular amount then cut herself a check for a significantly larger figure. For example, a bill would be $2,072 and Dee would cut a check for $7,072. Over 4 years this totaled over $200,000. One thing that may have averted suspicion in the past was that there had been somewhat legitimate sounding descriptions for the amounts. So in the case of this $5,000 it might have said $3,200 travel, $1,800 tickets. Everything was documented and if Quickbooks was the only information source relied on it might not arise suspicion.

The other way she embezzled was to put personal expenses on a Visa card. These were hundreds or thousands of dollars a month for gas, food etc. This totaled over $50,000 but since it was in smaller increments wasn’t as visible initially from a cursory look at the books.

The investigation was really just getting started after Dee left, and the environment was more relaxed in some ways, as I no longer had concern about a possibly unscrupulous and potentially unstable employee being 10 feet away from my workspace. I began calling certain vendors as some items were just listed as “Travel package” or US Air. What I found were personal vacations and concert tickets for tens of thousands of dollars, and some cases where she just paid herself cash with no backup.

I reviewed her computers and emails and was able to find evidence of ticket purchases but no connection to others at the company or anything much of interest. I reviewed and documented Dee’s and other employee’s transactions and sampled many cash transactions.

Meanwhile the company’s management, which had seemed quite surprised by the turn of events, used a law firm to protect their rights and find out what assets Dee had and began a court process. They got an ex parte judgment on a recently purchased home quickly, and alerted the police.

This was a very interesting engagement for me, one which began from a combination of some healthy skepticism, my investigative nature and perhaps some “luck” of being in an engagement where fraud already existed. At any rate, it inspired me to become a CFE and I will hopefully be involved with more cases in the future.

Preventing Fraud in Troubled Companies

Especially in difficult economic times banks are under increased scrutiny from their regulators, resulting in increased pressure on borrowers. This pressure may get to the point where the bank “calls the loan”. This refers to the bank demanding that the loan be paid in full as the result of a covenant violation or potentially a condition which is more severe, such as the company has run out of money to operate.

In privately held companies, owners often feel the pressure to preserve what is left of their company (which is often their life) and attempt to devise a plan to emerge from a financially challenging situation. These parties will not always be able to devise such a plan which results in the pressure which can sometimes lead to parties doing things which we see as Fraud.

When there are extreme creditor/lender pressures and an owner may not see any clean way out, the environment is ripe for fraud to occur. For example, a company may make preferential payments to certain creditors in an effort to preserve a relationship or more importantly where a personal guaranty may have been given. It is somewhat common for debtors to setup bank accounts at new banks and try to defraud the original lender by siphoning funds to another location. This can be done for two reasons, first to outright defraud a bank, secondly to keep a flailing business alive. Accounts are sometimes set-up out of state or at other institutions where the primary lender will not be able to get their hands on the funds.

During the time when a bank is closing or restructuring a business it is very attentive to the activities and movements of funds. It may liquidate certain assets or just monitor the collection of receivables and new sales in an effort to get its loan paid down and preserve a secured position. It is quite common for lenders under these circumstances to hire a turnaround/workout firm to either assist the company in restructuring or perform an orderly liquidation of the company, thus maximizing a recovery on the loan amount.

Some of the tools that work-out professionals utilize are accounts receivable and inventory roll-forwards, which track cash, accounts receivable, inventory and accounts payable. These analyses are different from those performed during a financial audit, and allow for increased scrutiny of cash. By comparing certain periods of data to other periods, variances can be recognized and relevant questions raised and researched. The job of the examiner or workout specialist is crucial in preserving the bank’s position. Banks require the expertise of CPA’s and CFE’s to work in these areas as they are beyond the scope of the banker’s expertise and time limitations.

I recently was in a workout engagement where a bank employed us to monitor the wind-down of a company which consisted of collecting existing accounts receivable and inventory in an effort to pay off the loan balance. While on-site, I made a review of financial records and noticed there were two sets of financial statements within the same accounting software. The differences between the two were in cash and some other less important accounts. The captions on the second balance sheet indicated cash at “Bank C” and “Bank E”. Bank E is where legal loan documents indicate all transactions should be occurring. Bank C had $85,000 of recent deposits and it appeared to be a way to divert funds that were supposed to be paying off the bank’s loan. The company’s cash records were not current and bank reconciliations were not done for months. A simple review of cash records and an accounts receivable roll-forward would have revealed the existence of these funds.

This case is just an example of fraud in a troubled situation. There was a minimal bank examination performed prior to our involvement but it did not uncover these items. Frankly, the examination was too little and too late. The report indicated over $200,000 of accounts receivable as having been collected, despite no documentation or accounting entries to support them. The owner and other family members were trying to keep track of actual receivable information in their head while reporting something different to their lender. It wasn’t until the company started bouncing checks that the lender became aware of an issue.

Periodic review of the company’s financial records and preparation of basic roll-forwards would have indicated the existence of incoming funds which never made it to the bank. The preventive steps indicated above, if initiated, would have resulted in a far more favorable outcome.

ABOUT THE AUTHOR: Bob BatesCPA, CVA, CFE, CFO of public companies with over 20 years of accounting experience.

He has worked on complex accounting treatments in addition to working at KPMG and is currently responsible for SEC filings.

He has done many acquisitions, performed SOX work, has done many valuations, stock options accounting and forensic work (discovered a $300,000 embezzlement and wrote an article in Fraud Magazine).

He has been involved in litigation support work and testifying with several court cases, including personal injury, alter ego, creditor, adversarial bankruptcy and employment-related cases.

Bob just completed an IPO in California and is a board member for Catalyst Group Holdings.

While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.